Nomura Special Report - When China Sneezes

If China sneezes The global implications of sub-6% growth in China

We construct a summary scorecard of indicators to gauge the relative exposure of 26 countries to China, through the export, commodity price and financial markets channels.

Our economists estimate the global impact of Chinas GDP growth slipping to 1pp below our baseline forecast of 6.9% in 2014 a scenario to which we attach a non-trivial 10-20% likelihood.

The hardest hit economies are in Asia; the impact is also large on Australia and Latam. Germany is one of the more exposed in Europe. The US is among the least exposed.

Global equities would unavoidably be set back by a China demand shock, but the biggest risks may not be in Asia-Pacific (or even China) stocks, but in resources-rich Latam, EEMEA and (somewhat surprisingly) the UK. Japan stocks would offer comparative safety.

We would expect China to hold the USD/CNY fix stable; AUD, CAD, BRL and KRW to suffer among the most; and MXN and PHP to be relative outperformers.

We would expect the China swap curve to invert and the UST curve to steepen. We would also expect AUD and EUR front-end rates to benefit and rates in Asia to broadly feel pressured lower.

GLOBAL MARKETS

RESEARCHJu l y 2013

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Principal Authors

Economists

Rob [email protected]+852 2536 7435Zhiwei [email protected]+852 2536 7435

Equity strategist

Michael Kurtz - [email protected]+852 2252 2182

Fixed Income strategist

Craig Chan [email protected]+65 6433 6106

See Appendix A-1 for analystcertification, importantdisclosures and the status ofnon-US analysts.

This document is being provided for the exclusive use of SIVASWAMI ASARY at BANK NEGARA MALAYSIA

Nomura | Anchor Report 23 July 2013

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Table of contents

1. Executive summary ................................................................................................. 3 2. China's downside risk scenario ............................................................................. 6

Chinas import elasticity .......................................................................................... 7 Fixed income strategy ............................................................................................ 8

3. Gauging Chinas relative economic impact a scorecard approach ................ 9 Export channel ........................................................................................................... 9 Commodity channel ................................................................................................. 12 Financial channel ..................................................................................................... 13 Nomuras scorecard of Chinas relative economic impact ....................................... 15

4. Global equity strategy ........................................................................................... 17 5. Country views on the downside risk scenario ................................................... 23

Japan ....................................................................................................................... 23 Economics ............................................................................................................ 23 Equity strategy ...................................................................................................... 24

South Korea ............................................................................................................ 25 Economics ............................................................................................................ 25 Equity strategy ...................................................................................................... 25 Fixed income strategy .......................................................................................... 26

Taiwan ..................................................................................................................... 26 Economics ............................................................................................................ 26 Equity strategy ...................................................................................................... 26 Fixed income strategy .......................................................................................... 27

Hong Kong .............................................................................................................. 27 Economics ............................................................................................................ 27 Equity strategy ...................................................................................................... 27 Fixed income strategy .......................................................................................... 30

ASEAN Indonesia, Malaysia, Singapore, Thailand, the Philippines .............. 31 Economics ............................................................................................................ 31 Equity strategy ...................................................................................................... 33 Fixed income strategy .......................................................................................... 33

India ......................................................................................................................... 34 Economics ............................................................................................................ 34 Equity strategy ...................................................................................................... 35 Fixed income strategy .......................................................................................... 35

Australia and Canada ............................................................................................ 36 Economics ............................................................................................................ 36 Equity strategy ...................................................................................................... 37 Fixed income strategy .......................................................................................... 38

Latin America.......................................................................................................... 41 Economics ............................................................................................................ 41

Europe ..................................................................................................................... 42 Economics ............................................................................................................ 42 Equity strategy ...................................................................................................... 50 Fixed income strategy .......................................................................................... 51

US ............................................................................................................................ 52 Economics ............................................................................................................ 52 Fixed income strategy .......................................................................................... 53

6. Recent Asia Special Reports ................................................................................ 55



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1. Executive summary1

We expect Chinas GDP to grow by 6.9% in 2014. Even though our forecast is near the bottom of consensus, we still see the risks skewed to the downside, given the high level of leverage in the economy and its slowing potential growth rate. In this report we outline a China risk scenario to our baseline, involving GDP growth slowing to 5.9% in 2014, and 5% in H1 2014. We believe that the likelihood of China experiencing this risk scenario is 10-20%, i.e. we no longer see it as a small tail risk because the economy faces stress from many dimensions, including financial leverage, pollution and social tensions.

Given the size of Chinas economy its nominal GDP at todays market exchange rates is on track to reach USD9trn this year, double the size in 2008 and its growing connectivity to the rest of the world, there is no doubt that the impact of a slowing China economy on the global economy will be much bigger than it was five years ago. To assess the global impact of this China risk scenario, in chapter 3 we first explain the various transmission channels through exports, commodity prices and financial markets and construct a summary scorecard of indicators to gauge the relative economic exposures of 26 countries. Building on this scorecard approach, in chapter 4 our country specialists attempt to quantify the impact on their own economies of Chinas 2014 GDP growth being 1 percentage point (pp) below our baseline forecast, taking into account the second-round effects from slowdowns in other economies, and the initial starting positions of countries in terms of economic strength, the scope for policy responses and idiosyncratic factors. In their analysis, they assume that global metal prices fall by 20-30% in 2014 and oil prices by 15-20%.

Economic impact

The overall result from this exercise is that a 1pp drop in Chinas GDP growth would lower global growth outside China by 0.3pp, but with a wide variation among economies (Figure 1). The hardest hit economies are in Asia, with growth falling by 1pp or more in Hong Kong, Singapore and Taiwan. The impact is also large on commodity-producing countries, such as Australia, Malaysia and those in Latin America indeed, despite being located much further away from China, the impact on GDP in Latin America (-0.5pp) is as large as that on Asia. In the euro area, the overall impact is -0.3pp. Aside from Ireland, which we believe is a special case, Finland, Austria, Belgium, Germany and the Netherlands are among the most exposed. Interestingly, the worlds largest economy the United States is among the least exposed.

Our economists estimate that headline CPI inflation generally falls, because of the double-whammy of weaker demand and falling prices of commodities, which have a big weight in the CPI baskets of emerging economies. The only exceptions are the large commodity producers in Latin America, for which the inflationary effect from significant currency depreciation dominates. Slowing growth and falling inflation paves the way for 13 of the 19 central banks to cut interest rates in 2014, the exceptions being those that have no scope, either due to the monetary policy framework or because policy rates are already at rock bottom, namely Japan, Hong Kong, Singapore, Canada, the US and the UK. The impact on current accounts varies among countries due to the tug of war between weaker exports and lower commodity prices. For commodity-producing countries, the current account surpluses narrow (or deficits increase), but in much of Asia the terms-of-trade effect dominates, increasing the (mostly) surpluses.

Equity strategy

Equities as the growth sensitive asset class would likely suffer more than other assets certainly fixed income. Of note, though, these risks appear more fully priced already into China H-share stocks themselves (after a five-year, 70% PBV de-rating) than in much of the rest of Asia-Pacific (or indeed Global) equity space. This extended China de-rating, along with the well-underway downshift in actual Chinese GDP growth from pre-global financial crisis highs, has already ushered substantial constructive declines in Global and Asian-regional equity correlations vs. China stocks. It is Japan, however, that offers the world's lowest equity correlation vs. H-shares by far, along with key fundamental firebreaks that make it an attractive defensive market in a China slowdown scenario.

1 This Anchor Report was a global research effort with Nomuras economic, equity and fixed income strategy teams over 40 authors in total contributing particular parts, and they are acknowledged in their respective sections. The principal authors are grateful to Candy Cheung for data assistance and David Vincent for editorial support.



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Looking at Global equity sectors, Materials still exhibit one of the strongest (though also declining) correlations with H-shares. As such, by region, stocks in the (Mining and Energy-intensive) UK, Latin America and EEMEA exhibit the MSCI Worlds highest and in this scenario, adverse correlations with China H-shares. Higher, in fact, than any of the other Asia-Pacific markets, where more listed-company activity is comprised of downstream value-added manufacturing that benefits from lower commodity costs. Conversely, despite perceptions that Chinese private consumption is more 'structurally' robust than China's investment cycle, relevant Global Consumer Goods stocks may not prove immune or 'defensive' in the China slowdown scenario. Indeed, the Consumer sector globally is now more highly correlated with China shares than are Materials.

Fixed income strategy

For global FX, a sharp slowdown in Chinas economy would have both direct and indirect negative impacts on commodity producers and countries with relatively large China trade links. Major currencies such as AUD and CAD would suffer from negative terms-of-trade shocks and both remain weaker for longer, with AUD/USD and USD/CAD likely reaching 0.88 and 1.10, respectively, by the end of 2014.

In Latin America, BRL would suffer the most (trading to 2.41 vs. USD by end-2014), through direct trade channels with China, lower global commodity prices and weaker US growth. MXN could be a relative outperformer given limited trade ties with China, but there could be some negative spill over from slower US growth.

In Asia, a sharp China slowdown would see the USD/CNY fix remain stable, in our view, but spot USD/CNY may trade to the weaker side of the daily trading band (currently 1%). Northeast Asian currencies are likely to be hurt given their strong economic links with China, with KRW (based on our analysis) being one of the more vulnerable. In Southeast Asia, open economies such as Singapore would be at risk from a slowdown in trade and potential capital outflows, while PHP would likely outperform given limited dependence on China, strong domestic-driven growth and favourable local fundamentals. Unlike the rest of Asia, the risk to INR would mainly be from the negative impact of China on global growth prospects given Indias dependence on equity flows to fund its current account deficit.

Looking at global rates, a sharp slowdown in Chinas economy would matter not only from a macro perspective but also from a capital-outflows perspective. Initially, we would expect USTs to rally, but if slowdown were to drag on, USTs may be negatively affected given the importance of Chinas buying of US fixed income assets. In Europe, however, we would expect the disinflationary effect of a China slowdown to be more impactful, which may result in the outperformance of the European swap curve, especially in front end. In Australia, we would expect a bull steepening of the curve as a China slowdown would allow the Reserve Bank to lower its cash rate further.

In Asia, we would expect a sharp China slowdown to result in a sharp inversion of the China swap curve, reflecting the combination of tight liquidity and low growth. We say this under the assumption that the Peoples Bank of China is expected to maintain a tight monetary policy stance well into 2014. We would expect the Korean curve to bull steepen, the Taiwan curve to bull flatten, and Hong Kong rates to outperform US rates (as would Singapore rates). In Southeast Asia, we would expect the Malaysian rates curve to bull flatten, whereas in Thailand and the Philippines our expected policy response to cut rates should see bull steepening. In India, we would expect rates to move lower, led by the front end of the curve.



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Fig. 1: Real GDP growth in 2014 under Nomuras base case and China risk scenario

Note: Aggregates are calculated using purchasing power parity (PPP) adjusted shares of world GDP. Source: Nomura Global Economics.

Base case China risk scenario Difference (pp)China 6.9 5.9 -1.0Global, ex- China 2.5 2.2 -0.3Asia 4.1 3.6 -0.5

Australia 2.1 1.4 -0.7Hong Kong 3.5 2.0 -1.5India 5.5 5.2 -0.3Indonesia 6.0 5.6 -0.4Japan 2.5 2.0 -0.5Malaysia 4.5 3.7 -0.8Philippines 6.2 5.9 -0.3Singapore 3.5 2.2 -1.3S. Korea 4.0 3.5 -0.5Taiwan 3.5 2.5 -1.0Thailand 4.8 4.2 -0.6

America 2.7 2.4 -0.3US 2.6 2.4 -0.2Canada 2.3 2.0 -0.3

Latin America 3.3 2.8 -0.5Brazil 1.8 1.3 -0.5Chile 4.0 3.6 -0.4Colombia 4.5 4.0 -0.5Mexico 4.7 4.3 -0.4

Euro area 0.0 -0.3 -0.3Austria 0.8 0.5 -0.3Belgium 1.1 0.8 -0.3Finland 0.9 0.5 -0.4France 0.5 0.3 -0.2Germany 0.7 0.4 -0.3Greece -1.6 -1.7 -0.1Ireland 1.3 0.8 -0.5Italy -1.2 -1.4 -0.2Netherlands 0.2 -0.1 -0.3Portugal -0.1 -0.3 -0.2Spain -1.5 -1.7 -0.2UK 1.4 1.2 -0.2



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Zhiwei Zhang +852 2536 7433 [email protected] Wendy Chen +86 21 6193 7237 [email protected]

2. China's downside risk scenario

In our baseline scenario, Chinas GDP growth slows to 6.7% in H1 2014 but recovers slightly in H2 such that our full-year forecast is for 6.9% growth in 2014. Both cyclical and structural factors contribute to this slowdown. Structurally, Chinas potential growth is on a downtrend due to a dwindling labour force and a lack of reform. Cyclically, the monetary policy stance has changed from its loose bias in H2 2012 and Q1 2013 to a tightening bias since Q2 2013. The systemic deleveraging process after such a profound period of credit growth is likely to last well into 2014, in our view (see China may enter a prolonged period of policy tightening, 24 June 2013).

In our risk scenario, GDP growth slows to 5.9% for full-year 2014 and to 5% in H1 2014. Given the high level of leverage in the economy, policy tightening may lead to a faster deleveraging process, higher interest rates and a credit crunch, all of which would combine to cause a sharp slowdown in economic growth.

Investment and consumption would both be affected by deleveraging, but investment would likely be hurt more. A wave of bankruptcies across those industries that face overcapacity problems is not too far-fetched, while property and infrastructure investments would slow due to financing constraints. Some non-bank financial institutions such as trusts would likely fail, while the banks face rising NPLs and require government assistance just to remain solvent.

We believe that the likelihood of China experiencing the risk scenario described above or worse is 10-20%. We see this no longer as merely a small tail risk with a 5% probability because the economy faces stress from many dimensions, including financial leverage, pollution and social tensions. Our proprietary China Stress Index rose to a record high of 101.6 in Q1 2013 from 101.5 in Q4 2012 (see Nomuras China Stress Index recorded highest level in Q1, 24 April 2013; Figure 2).

We flag, in particular, the speed of the build-up of leverage. The credit-to-GDP ratio has increased by 34pp in the past five years similar to the experience at various times through history in the US, Japan and Europe after which all suffered financial crises (see Asia Special Report: China: Rising risks of financial crisis, 15 March 2013). Moreover, if shadow financing activities are included, the debt buildup has been around 60pp over the same period. The recent liquidity squeeze in June reveals the fragility of the financial system, as the 7-day repo rate rocketing to 28% intraday on 20 June (Figure 3).

We do not take the risk scenario as our baseline case, because we think the government can take action to smooth out the deleveraging process and growth slowdown so as to avoid financial sector meltdown. The banking sector is fully under the government control. We do not think government will allow banks to fail. Hence the transmission of corporate default may not be amplified through bank failure. This is the key difference between financial risks in China and market economies.

Fig. 2: Nomuras China Stress Index

Source: Nomura Global Economics.

Fig. 3: 7-day repo rate

Source: Bloomberg and Nomura Global Economics.

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Chinas import elasticity When considering the notion of a harder China landing and its effects on other economies, it is misleading to calculate their trade linkage with China by looking at Chinas total imports. First, commodity prices are volatile and can thus distort the value of total imports as China is a voracious importer of commodities. Moreover, China imports a lot of parts for processing and re-exporting purposes. We therefore estimate the elasticity for imports excluding commodities and processing trade. We label this as ordinary imports in Figure 4 and believe it is more representative of Chinas imports driven by its domestic demand. We estimate that, if GDP growth drops by 1%, growth of ordinary import drops by 10.9%.

For commodity imports, we estimate the elasticity of iron ore, crude oil and copper, separately, in volume terms. The elasticity is 4.2 for iron ore, 5.7 for crude oil and -2.0 for copper (Figures 5-7). The negative elasticity for copper may be due to the copper-financing business in China when credit tightens, growth slows and some companies manage to borrow from banks by importing copper.

Fig. 4: GDP growth and ordinary import growth

Source: CEIC and Nomura Global Economics.

Fig. 5: GDP growth and iron ore import growth


Fig. 6: GDP growth and crude oil import growth


Fig. 7: GDP growth and copper import growth


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Craig Chan +65 6433 6106 [email protected] Prashant Pande +65 6433 6198 [email protected]

Vivek Rajpal +65 6433 6555 [email protected] Prashant Pande +65 6433 6198 [email protected]


FX: A sharp slowdown in China's economy would likely stall CNY appreciation on a fix basis and raise the risk of some depreciation in RMB spot and forward markets. We currently forecast a stable USD/CNY fix at 6.160 (6.1721 last) in 2014, while spot USD/CNY should rise to around 6.160 (6.1388 last). However, if China downside growth concerns are elevated, there is a risk of spot USD/CNY rising to the extreme weak side of the daily trading band, which would be 6.222 based on a 1% band. If the band is widened to 2%, spot USD/CNY could rise to 6.283. We expect limited deviation in spot USD/CNH from spot USD/CNY, given the increase in trade-related FX arbitrage.

The importance of the economic cycle for RMB is reflected in our dummy variable regression analysis2 with industrial production growth and inflation. Our results show the relationship between economic conditions and changes in USD/CNY, which highlights the risk to RMB appreciation if IP growth and inflation were to slow. During the US financial crisis, China kept USD/CNY virtually fixed. It was only in July 2010, when deflation in China ended and IP growth stabilised, that authorities shifted back to a more basket-orientated FX regime. Although it could be different this time, as this growth slowdown has been led by a significant weakening in domestic demand (rather than a weakening of the external sector), there would likely be a similar FX policy response to a severe China economic slowdown.

However, even with an effective peg on the USD/CNY fix, there is a risk of RMB depreciation in spot and FX forward markets from capital outflows. A repeat of the experiences in Q4 2011 and mid-2012 (European debt crisis), when spot USD/CNY tested the extreme weak side of the daily trading band, is possible. China, from March to May 2012 (when the European debt crisis intensified), lost USD55.6bn in FX reserves (adjusted for FX valuation and coupon payment effects). Although China appears to be less vulnerable to capital flow shocks (given the limited amount of foreign ownership/participation in local markets) and ample FX reserves cushion potential outflows (FX reserves to short term debt and imports at 6.2 times and 22.6 times respectively), there are concerns that a sharp economic slowdown could lead to financial/credit defaults and/or social unrest.

Rates: As highlighted by our economists, the Peoples Bank of China (PBOC) is expected to maintain a tight monetary policy stance well into 2014 in order to facilitate a systemic deleveraging process. The tightening bias since Q2 2013 has already had an impact on 7-day repo rate fixings. The fixing rose to a high of 10.77% in June, before dropping as the PBOC skipped bills and repo issuances while maturing repos provided a reprieve to the liquidity situation. In our view, tight liquidity conditions into 2014 will continue to exert upward pressure on the front end of the IRS curve. However, growth is likely to slow in H1 2014 (according to our baseline scenario), which would restrict upside in the longer end of the curve. In our view, the interplay between tight liquidity conditions and slowing growth could lead to an inverted IRS curve, as seen in June, and can be expressed through initiating IRS flattener trades at appropriate levels. This position will be further supported in a scenario where Chinas growth slows alarmingly while liquidity conditions remain tight.

2 A multi-variate linear regression was run for monthly changes in USD/CNY (from Aug 2005 to Jun 2013) against CPI (%y-o-y), IP (%y-o-y), a China event dummy variable and China NEER basket implied spot (%m-o-m). The resultant model has an R-squared of 31%. Regression was conducted in USD/CNY terms, so the inflation coefficient should be negative (i.e., when inflation is relatively high, USD/CNY should be falling relatively rapidly). The coefficients and P-values are (-0.08%, 0%) for CPI, (-0.01, 41%) for IP, (-0.10, 30%) for China event dummy variable and (0.08, 0%) for China NEER basket implied spot.



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Rob Subbaraman +852 2536 7435 [email protected] Candy Cheung +852 2536 7436 [email protected]

3. Gauging Chinas relative economic impact a scorecard approach

Given the size of Chinas economy its nominal GDP at todays market exchange rates is on track to reach USD9trn this year, double the size in 2008 and its growing connectivity to the rest of the world, there is no doubt that the impact of a slowing China economy on the global economy will be much bigger than it was five years ago. The IMF, using a simple global VAR model, estimates that a 1pp fall in Chinas GDP growth would reduce total GDP growth in advanced economies by 0.1pp3. But in practice, it is very difficult to quantify precisely the economic impact because of all the indirect and second-round effects that feed into the outcome through commodities, investment flows and financial markets. Moreover, the impact can vary substantially across countries.

In this chapter we take a different approach. Instead of estimating the economic impact, we measure the relative economic vulnerability of each country to China. We do this using a scorecard of indicators that are all based on three channels of exposure: either exports to China, commodity prices, or financial effects.

Export channel In the past decade, exports to China have increased exponentially in most countries. By 2012, China had become the top export market for Australia, Hong Kong, Japan, Korea, Taiwan and Thailand. It was second-largest for Indonesia and Malaysia, and third-largest for India, the Philippines and Singapore.

To more accurately assess a countrys economic exposure from its direct exports to China it is important to also take into account the size of a countrys total exports in its GDP. As such, the metric we prefer to use is that of exports to China, as a percentage of each countrys GDP (Figure 8).

For example, a hefty 29% of Australias exports were shipped to China last year, but Australia is a relatively closed economy, with its total merchandise exports comprising only 17% of GDP. Therefore, Australias exports to China as a percentage of GDP are 4.9%, which is around the median in Asia, although relatively high on a global comparison. At the other extreme is Malaysia: 13% of its total exports were shipped to China last year, but it is a very open economy, with its merchandise exports comprising 75% of GDP. As such, Malaysias exports to China as a percentage of its GDP are a relatively high 9.4%.

Fig. 8: Merchandise exports to China, 2000 versus 2012

Note: Hong Kong data is for domestic exports to China. Source: ABS, CEIC, IMF, Eurostat and Nomura Global Economics.

3 See Peoples Republic of China: Spillover report for the 2011 article IV, Country report No. 11/193, July 2011.

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However, the numbers in Figure 8 overstate each countrys true direct export exposure to China and hence the importance of Chinese final demand, because they do not take into account the boom in processing/assembly trade in China. Chinas accession to the WTO in December 2001 resulted in a substantial opening of its markets to foreign companies. Many multinationals set up factories in China to utilize the competitive and abundant supply of cheap labour and other resources. The implication is that a large share of exports to China is made up of high value-added parts and components that are assembled and subsequently re-exported to end-markets in other countries.

The distinction between those exports that stay in China, and those that get re-exported, is important. In 2009, the slump in exports to China was largely seen in intermediate exports, reflecting the collapse in final demand in the big advanced economies; indeed, Chinas net exports subtracted 3.5pp from GDP growth that year, whereas Chinese domestic demand added a whopping 12.6pp, reflecting the massive fiscal stimulus. So, back then, China was a support for the rest of the worlds exports. In contrast, the contemporary slowdown in Chinas economy is being internally driven by weakening Chinese domestic demand (notably investment), not net exports. And so for the first time in a long time, China has become a headwind for the rest of the worlds exports.

Nomuras Chief China economist, Zhiwei Zhang, utilized a unique firm-level database to separate these intermediate exports to China that are re-exported from those that stay (see Can Demand from China shield East Asian economies from global slowdown?, HKMA Working paper No. 19/2008, December 2008). A drawback of the detailed data is that they are somewhat dated, being for 2006, but the results are revealing. Out of total exports, the share shipped to China, once adjusted for the intermediate exports that are re-exported, drops by 60% for the Philippines, and by roughly 50% for Japan, Korea, Malaysia, Singapore and Thailand, with commensurate increases in share to other markets (Figure 9).

The OECD and WTO, drawing on input-output production tables, have also created a special database on global value-added trade for 58 countries, isolating only the value-added content of exports (see on the OECD website, OECD-WTO Trade in Value Added (TiVA) - May 2013).



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Fig. 9: Disentangling the true export exposure to China Exporter Export market Direct export Indirect export Direct and indirect exposure 1 exposure 2 export exposure Japan U.S. 22.8 1.9 24.7 Japan Japan 0.0 1.1 1.1 Japan Rest of OECD 18.0 1.6 19.6 Japan China 20.0 -9.2 10.8 Japan Rest of World 39.2 4.7 43.9 Australia U.S. 6.2 0.3 6.5 Australia Japan 19.6 0.3 19.9 Australia Rest of OECD 19.1 0.6 19.7 Australia China 14.2 -2.7 11.5 Australia World 40.9 1.5 42.4 Indonesia U.S. 11.5 0.5 12.0 Indonesia Japan 19.4 0.3 19.7 Indonesia Rest of OECD 15.8 0.5 16.3 Indonesia China 9.2 -2.8 6.4 Indonesia Rest of World 44.0 1.6 45.6 Korea U.S. 13.3 2.8 16.1 Korea Japan 8.1 1.5 9.6 Korea Rest of OECD 16.1 2.2 18.3 Korea China 27.2 -13.5 13.7 Korea Rest of World 35.3 7.0 42.3 Malaysia U.S. 18.8 1.5 20.3 Malaysia Japan 8.9 0.6 9.5 Malaysia Rest of OECD 16.3 1.2 17.5 Malaysia China 12.2 -6.2 6.0 Malaysia Rest of World 43.8 2.9 46.7 Philippines U.S. 18.3 2.5 20.8 Philippines Japan 16.5 1.0 17.5 Philippines Rest of OECD 20.0 2.1 22.1 Philippines China 17.7 -10.7 7.0 Philippines Rest of World 27.6 5.0 32.6 Singapore U.S. 10.2 2.3 12.5 Singapore Japan 5.5 1.0 6.5 Singapore Rest of OECD 15.5 1.9 17.4 Singapore China 19.9 -9.9 10.0 Singapore Rest of World 49.0 4.6 53.6 Thailand U.S. 15.0 1.9 16.9 Thailand Japan 12.6 0.8 13.4 Thailand Rest of OECD 18.6 1.5 20.1 Thailand China 14.6 -7.7 6.9 Thailand Rest of World 39.2 3.5 42.7

Note: This table measures the direct and indirect bilateral export exposure for East Asian economies to their major trading partners in 2006. The direct exposure is based on the share of economy A's exports to five export markets relative to its total exports, without taking into account its exports to China that were processed and re-exported to other economies. The indirect exposure is A's exports to China that were processed and re-exported to other export markets, as a share of A's total exports. The two measures combined provide an accurate estimate for bilateral export exposure. Source: Hong Kong Monetary Authority.

Drawing on the estimates by Zhiwei Zhang and the OECD-WTO TiVA database, we apply adjustment factors to remove those intermediate exports to China that are re-exported. After these adjustments, we calculate that the economies of Singapore, Taiwan, Malaysia and Korea are among the most exposed to exports to China (Figure 10). Nine of the 12 most exposed are in Asia, along with Chile, South Africa and Germany.



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Fig. 10: Exports to China adjusted for intermediate goods that are re-exported, 2012

Note: Hong Kong data are for domestic exports to China. Source: CEIC and Nomura Global Economics.

Commodity channel The indirect impact of a sharp investment-led China downturn, via a slump in commodity prices, stands to be substantial for some countries. China has become a dominant importer across a range of commodities, most notably hard commodities. In metals, Chinas per capita intensity now rivals that in advanced economies. It accounts for some 30% of the worlds total imports of metals and a full 65% of total iron ore imports globally. In energy, Chinas share of world imports is in the high single digits, while for food it is low single digits, with the substantial exception of soybeans, at over 50%.

The IMF (see Country report No. 11/193), using a simple model, has estimated that a 1pp fall in Chinas GDP growth can result in price declines of 6% for oil and base metals. We suspect though that this is a gross underestimate for three reasons: 1) second-round effects, a China downturn slows growth elsewhere, which further weakens demand for commodities; 2) the high degree of financial speculation in global commodity prices, which is likely to exacerbate the price declines; and 3) the limitation of models. The point estimates from models give the historic average result over the data sample period, yet Chinas economic importance has increased substantially in such a short period, the size of its economy doubling in just the past five years. Recursive estimates by the IMF shows that, in general, Chinas effect on global commodity prices has been growing over the last five years (see Chinas impact on world commodity markets, IMF Working Paper No. 12/115, May 2012). For our analysis in the next chapter, we have assumed that if Chinas GDP growth in 2014 is 5.9%, instead of our base case 6.9%, global metal prices would fall by 20-30% and oil prices by 15-20%, while soft commodity prices are less affected. To gauge the relative exposure to this slump in commodity prices, we estimated the share of non-food related commodities in each countrys total merchandise exports. The results show that it is mostly emerging markets that are most exposed to this channel, most notably Russia, Chile, Australia, Indonesia, South Africa, Finland, Brazil and Canada (Figure 11).

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Fig. 11: Percentage share of non-food commodities in total exports, 2000 versus 2012

Note: Non-food commodities are estimated from the United Nations Comtrade database. At the first-digit SITC classification level, we combine five categories: Inedible crude materials, mineral fuels, lubricants and related materials, animal and vegetable oils, fats and waxes, chemicals and related products and manufactured materials. Source: CEIC, UNCTAD and Nomura Global Economics.

Financial channel With the opening up of its capital account and the gradual internationalization of the renminbi, Chinas influence on global financial markets is also increasing. A China economic slowdown could have several negative effects on global financial markets, including a decrease in profitability of FDI investments in China; less Chinese investments overseas; a deterioration in the balance sheets of global banks with loan exposures in China; and financial market contagion through sagging equity markets and depreciating currencies.

From these transmission mechanisms, the real economies can be affected through financial decelerator effects. These can range from negative wealth and confidence effects, from swooning equity markets to tighter liquidity and credit conditions as a result of net capital outflows, and banks rationing credit. Compared to the export and commodity channels, the financial channel is the most difficult to gauge because of the paucity of data and its indirect effects. We use four proxies.

Complete data on investments in and out of China, on a country by country basis, are unavailable, but China does have annual data by country on FDI inflows. Scaled by the size of the investing countrys GDP, the results show that Hong Kong is by far most exposed (Figure 12).

Fig. 12: FDI inflows to China in 2011

Source: CEIC, IMF IFS and Nomura Global Economics.

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Of course, Hong Kong plays the role of being Chinas largest financial conduit to the global economy. A significant proportion of Hong Kongs FDI flows to China are actually from the foreign subsidiaries of other countries that are based in Hong Kong. There is also what is known as round-tripping: part of the FDI flows from China to Hong Kong go back again, but are really other investments disguised as FDI in order to take advantage of Chinese regulations and taxes that favour foreign capital. Overall, we regard FDI inflows to China as a useful proxy for the significant level of financial integration between Hong Kong and mainland China.

Similarly, data on Chinas outward foreign investments on a country by country basis are sparse. Chinas overseas portfolio investments are largely conducted by the official sector (i.e. FX reserves), and are concentrated in deep, liquid and high-grade fixed-income markets, notably in the US. What is available, by country, is Chinas outward FDI, which is likely correlated with Chinese bank lending overseas (mostly to Chinese companies). Like inward FDI, these data show that Hong Kong is by far the largest destination of Chinas FDI, followed by Singapore (Figure 13). In support of the FDI data showing the high level of financial integration between Hong Kong and mainland China, data from the Hong Kong Monetary Authority (HKMA) show a surge in Hong Kong bank exposure to companies on the mainland, from 50% of GDP in 2008 to 139% in March 2013 (Figure 13).

Fig. 13: FDI outflows from China in 2011

Source: CEIC, IMF IFS and Nomura Global Economics.

Fig. 14: Hong Kong banks non-bank China exposure

Note: Hong Kongs banking sector non-bank China exposure refers to the amount of lending to mainland China by Hong Kongs banking sector as a whole. The figures of Non-bank China Exposures (NBCE) include exposures booked in the retail bank branches and subsidiary banks in mainland China. NBCE can include: International Trust and Investment Corporations and their subsidiaries; H-share companies and their subsidiaries; other state, provincial or municipal government-owned entities and their subsidiaries; other entities incorporated or established in China; companies and individuals outside China where the credit is granted for use in China; and other counterparties where the exposure is considered by the reporting institution to be non-bank China exposure. Source: HKMA and CEIC.

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To measure the potential financial contagion from China we use two proxies. One is the average correlation of the daily returns on the Shanghai composite index to that of other countries benchmark equity market indexes. Here the results show a marked increase in correlation for all countries in 2009-13 compared to 2000-05 (Figure 15). The highest correlation coefficients with Chinas bourse since the financial crisis is with the equity markets in Hong Kong (0.54), and many of the most correlated bourses are those in Asia. The other proxy is the correlation between daily returns on spot local currency per USD against CNY/USD. Here too, there has been a noticeable increase in correlation in 2009-13 compared to 2000-05 when the CNY/USD rate was fixed for most of the period. The highest correlation coefficients with CNY/USD are with the currencies of Singapore, Taiwan, the euro area and Thailand (Figure 16).

Fig. 15: Equity market correlations with China


Fig. 16: FX correlations with China

Source: Bloomberg and Nomura Global Economics.

Nomuras scorecard of Chinas relative economic impact To summarize the total impact of the three channels, we have created a scorecard (Figure 17). We convert each of the six China vulnerability indicators into indexes and rebase them so that the average level of each for the 26 countries surveyed is 100. We then subjectively weight the indexes, applying 40% to the export channel, 30% to the commodity channel and 30% to the financial channel. The conclusion from this exercise is that the economies of Hong Kong, Singapore and Taiwan are among the most vulnerable to a deeper than expected China growth slowdown. Asia is particularly vulnerable, accounting for eight of the 12 most exposed economies. Chile and Brazil appear to be the most exposed in Latin America, while Russia and South Africa are also quite vulnerable. Finland and Germany are among the most exposed in Europe. At the other extreme, the least exposed are the US, Mexico and the Philippines (Figure 18).

The virtue of this scorecard approach is that it is a straightforward and intuitive way to assess relative economic vulnerabilities to China. But it has limitations. The second-round economic effects of a China growth slowdown impacting economy A which in turn affects economy B,

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have been ignored. Also important but neglected, are the initial starting positions of countries in terms of economic strength, the scope for policy responses and idiosyncratic factors.

In Chapter 5, our economists take on board these factors as they attempt to quantify the impact on GDP growth, inflation, the current account and policy rates, in a scenario in which Chinas GDP growth in 2014 is a full percentage point below our baseline forecast of 6.9%. Armed with these estimates, our equity and fixed income strategists then consider the market implications for individual countries. However, first we take a look at the Global Equity implications.

Fig. 17: Nomuras scorecard components

Scorecard indicators, indexed so that 100 = sample average

Adj. exports to China Non-food commodity

exports China outward

FDI China inward

FDI Equity market Currency Scorecard

% GDP % total exports % recipient countries' GDP % of investing countries' GDP

Correlation coefficient

Correlation coefficient

Weights 0.4 0.3 0.05 0.05 0.1 0.1 1.0 Australia 88 170 15 1 101 98 107 HK 7 105 980 985 154 91 157 India 16 107 1 0 81 110 58 Indonesia 49 170 5 0 106 73 89 Japan 36 62 0 4 89 29 45 Korea 151 87 0 8 110 104 108 Malaysia 156 113 2 4 87 112 117 Philippines 38 40 8 2 58 100 43 Singapore 227 102 84 79 115 132 155 Taiwan 223 86 0 16 105 128 139 Thailand 107 58 5 1 93 124 82 Brazil 33 130 0 0 56 58 63 Canada 22 129 2 1 49 90 61 Chile 90 179 0 0 56 60 101 Finland 27 139 0 1 54 125 71 France 15 90 9 1 53 125 51 Germany 51 75 1 1 49 125 60 Italy 12 90 1 1 43 125 48 Mexico 10 66 0 0 53 69 36 Portugal 10 106 0 0 46 125 53 Russia 34 205 3 0 80 92 92 S. Africa 55 153 0 0 83 79 84 Spain 7 96 1 1 41 125 48 Turkey 7 95 0 0 41 94 45 UK 13 101 4 1 61 79 50 US 14 89 1 1 32 0 35

Note: The export data are for 2012, FDI data for 2011 and correlation coefficients are over 2009-13. Adjusted exports to China are each country's total exports to China less our estimate of intermediate goods shipped to China that are re-exported. For the currency correlation coefficient, we have assigned no correlation between the US and CNY, given the USD is the world's reserve currency. Source: CEIC, Bloomberg, ABS, China Statistical Yearbook, IMF IFS, UNCTAD and Nomura Global Economics.

Fig. 18: Nomuras scorecard of overall economic impact

Source: CEIC, Bloomberg, ABS, China Statistical Yearbook, IMF IFS, UNCTAD and Nomura Global Economics.

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Michael Kurtz +852 2252 2182 [email protected] Mixo Das +852 2252 1424 [email protected] Yiran Zhong +852 2252 1413 [email protected]

4. Global equity strategy

Given how important Chinese demand has been to global marginal GDP growth in recent years, equities as "the growth sensitive asset class would seem likely to suffer relative to other asset classes certainly fixed income in a deeper-than-expected China slowdown scenario. That said, we note that markets are already attaching a substantial discount to Chinese stocks and in certain key areas outside of China Chinese demand expectations.

As Figure 19 demonstrates, Chinese stocks themselves have underperformed the MSCI World Index by no less than 33% since July 2009, and one has to go back to the pre-global financial crisis period (i.e. 2007) to observe an extended period of trend outperformance.

Fig. 19: Chinese market relative performance MSCI China / MSCI AC World (Jan 2001 = 100)

Source: Bloomberg, Nomura Strategy Research.

Moreover, this price underperformance has not been matched by a similarly poor earnings trend, meaning China market multiples have been heavily de-rated to the point, in fact, where the valuation discount now being applied to Chinese equities is the largest since mid-2003.

Fig. 20: Chinese market multiple relative to global market 12m Forward PER: MSCI China / MSCI AC World

Source: IBES, FTSE, Nomura Strategy Research.

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Chinese equities are also trading at historic discounts versus other Emerging Markets (Figure 21).

Fig. 21: Chinese market multiple relative to global EM 12m Forward PER: MSCI China / MSCI EM

Source: FTSE, Nomura Strategy Research.

As expectations for Chinese growth have already moderated substantially in the past two to three years, correlations between Chinese equities and other global and even Asian-regional equity markets have declined substantially, as Figures 22 and 23 illustrate. Short of hard landing risks, China appears gradually to be losing its power to spoil the party elsewhere.

Fig. 22: China H-share Index correlation vs. MSCI World

Source: Bloomberg, Nomura Strategy.

Fig. 23: China H-share Index correlation vs. MSCI APXJ


Indeed, a look at recent years statistical correlations between China H-shares and MSCI World key regions and sectors (based on 26-week USD-denominated returns Figure 24) offers insight both into where such China correlations have declined the most but also where the risk of equity market contagion may still be greatest. In most cases, these correlations also comport with our fundamental sense as to how the real and financial effects of a deeper Chinese growth slump would propagate through the global equity space.

Given Chinas predominant role as a driver of global marginal demand for commodities, at the global level the Materials sector (at the GICS-1 level) still exhibits one of the strongest correlations with H-shares, at 0.62.

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Note, however, that due to the larger decline in Materials-sector correlations since the height of the financial crisis, H-share correlation with the Materials sector is now (slightly) lower than those with Consumer Discretionary and Financials both at 0.64. At its March 2012 peak of 0.91, Materials had previously been the most correlated global sector with China stocks.

By contrast, lower-beta relationships (i.e. vs. H-share returns) are generally found among the classically defensive sectors (e.g. Utilities, Staples and Healthcare). In other words, positive China-share performance should tend to be associated with outperformance in riskier assets or more cyclical sectors (as seems intuitively logical); but a China-driven rollover could best be sidestepped through exposure in low-beta names.

Fig. 24: China H-share correlation vs. global sectors (26-week USD-denominated returns)


By key global region (Figure 25), other than the Asia-Pacific ex-Japan region itself (where China's incumbency forces an unavoidable auto-correlation), it is the UK (somewhat surprisingly) and Latin America, that exhibit the MSCI Worlds highest 26-week return correlations with China H-shares.

The former, we think, is largely attributable to the fact that UK equities are heavily weighted in Mining and Energy (as indeed are Latin American and EEMEA stocks).

Also noteworthy is the fact that ex-China/Hong Kong themselves (again due to auto-correlation), most of the individual Asia-Pacific ex-Japan regional markets exhibit lower correlations with China H-shares than do either the (other) Emerging Market regions (i.e. Latin America and EEMEA) or Europe and the UK. As we have dissected in previous reports (see China slows, Japan goes, Gold knows, 9 May 2013), in large measure we believe Asia's comparatively lower correlation reflects the degree to which much of Asian corporate activity is comprised of downstream value-added manufacturing that benefits from lower input costs. However, more mechanistically, it may simply be due to portfolio allocations within the confines of the Asia-Pacific ex-Japan benchmarked universe, wherein flows that reallocate from China would be limited for choice only to the other markets of the region (and vice versa).

We also note that Japan exhibits the MSCI World's lowest correlation vs. China H-shares by far, at just 0.25 suggesting substantial 'defensive' qualities in a deeper-than-expected China slowdown scenario. Not only do Japanese stocks exhibit the lowest-beta relationship with China H-shares among the major global markets, but Japans domestic consumption-heavy GDP composition and the independence of the Bank of Japans (currently very loose) monetary policy should help insulate it from a Chinese demand slowdown.

MSCI AC World Sectors 2002-07 Avg. GFC Peak Peak Month/Year Current Change vs. PeakDiscretionary 0.52 0.88 Mar-09 0.64 -0.25Energy 0.40 0.82 Jul-09 0.51 -0.31Financials 0.48 0.85 Mar-12 0.64 -0.20Healthcare 0.23 0.77 May-09 0.41 -0.34Industrials 0.49 0.88 Apr-09 0.59 -0.29IT 0.47 0.85 Apr-09 0.55 -0.33Materials 0.53 0.91 Mar-12 0.62 -0.29Staples 0.31 0.84 Apr-09 0.42 -0.42Telecom 0.41 0.89 Mar-09 0.52 -0.37Utilities 0.34 0.75 Sep-10 0.39 -0.35



20

Fig. 25: China H-share correlations vs. Major global region (and by Asia-Pacific country) (26-week USD-denominated returns)


Despite the decline from global financial crisis peaks in all global equity correlations vs. China, a deeper-than-expected slowdown in the Chinese economy would still have far-reaching consequences for global equities. The Materials and Energy sectors, once regarded as key beneficiaries of structurally strong Chinese demand, remain center-screen in that regard. But as seen in Figure 26, these sectors have been markedly underperforming globally since as early as late 2011 suggesting moderating China growth over the next several quarters has to some degree been discounted.

Fig. 26: Relative performance of Global Energy and Materials sectors MSCI AC World sector indices

Source: FTSE, Nomura Strategy Research.

Still, given that the scenario discussed in this report invokes a China slowdown more heavily concentrated within the investment component of GDP, it is the Metals & Mining stocks that may yet have most to lose: The global mining industry invested heavily to expand capacity in the immediate post-crisis years as Chinas demand was artificially boosted by aggressive fiscal stimulus. Assuming demand from China slows further, those investments are far less likely to prove profitable on a relevant timeframe (see Chinese copper demand vs. global copper prices; Figure 27).

2002-07 Avg. GFC Peak Peak Month/Year Current Change vs. PeakUS 0.37 0.84 Apr-09 0.54 -0.30Europe 0.43 0.82 Mar-09 0.62 -0.20UK 0.39 0.85 Mar-09 0.70 -0.15Japan 0.46 0.83 Jan-08 0.25 -0.58Asia-Pacific ex-Japan 0.76 0.97 Mar-12 0.83 -0.14 Australia 0.51 0.85 Jan-08 0.58 -0.28 Hong Kong 0.79 0.95 Dec-11 0.82 -0.13 India 0.42 0.89 Mar-09 0.58 -0.31 Indonesia 0.33 0.91 Aug-11 0.58 -0.32 Korea 0.54 0.87 Sep-11 0.50 -0.37 Malaysia 0.43 0.84 Dec-11 0.47 -0.37 Philippines 0.28 0.83 Jan-08 0.56 -0.26 Singapore 0.60 0.92 Sep-11 0.54 -0.38 Taiwan 0.53 0.85 Oct-10 0.61 -0.31 Thailand 0.40 0.90 Feb-12 0.57 -0.33EEMEA 0.49 0.92 Jan-12 0.65 -0.27LatAm 0.45 0.91 Mar-12 0.69 -0.22

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Fig. 27: Chinese copper import volumes and the price of copper

Note: Imports of unwrought copper and products. Source: Datastream, Nomura Strategy Research.

With downward pressure on global commodity and energy prices, we would expect top-line revenue slippage in equity markets dominated by upstream-sector (i.e. primary industry) activity, such as Metals & Mining, Oil & Gas Exploration & Production and Agriculture; whereas downstream sectors (e.g. Manufacturing, Refining & Petrochemicals, Power Generation) could at least derive potential flow-through benefits to bottom-line profitability.

As shown in Figure 28, global equity regions with the greatest primary-industry vulnerability as a percent of market capitalization to softer primary goods prices include EEMEA (20.5%) and Latam (18.1%). By comparison, Asia-Pacific ex-Japan suffers half the exposure of its EM cousins, at just over 10%. These measures of vulnerability jibe well with the higher H-share correlations noted earlier particularly for Latam.

By contrast, the greatest beneficial downstream industry exposure to lower input prices principally include Japan (45.9%) and the ex-Japan Asia-Pacific region (27.6%), followed by the US (24.9%).

Fig. 28: Asia ex-Japan: upstream vs. downstream sector exposure (% market cap)

Source: Datastream, Nomura Strategy Research.

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US Europe Japan APxJ EEMEA LatAmUpstream Exposure Aluminum 0.1 0.1 - 0.1 - -Steel 0.1 0.3 1.7 1.2 1.1 9.1Diversified Metals & Mining 0.2 2.6 0.4 3.6 2.8 2.8Gold 0.1 0.1 - 0.3 1.9 -Coal & Consumable Fuels 0.1 - - 0.7 0.3 -Oil & Gas Exploration & Production 2.6 0.3 0.4 2.4 3.2 -Integrated Oil & Gas 3.2 4.4 - 0.8 11.1 5.4Agricultural Products 0.2 - - 0.6 0.1 -Tobacco 1.6 1.9 1.5 0.7 - 0.8

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Downstream Exposure Industrials 10.2 11.5 19.1 7.8 3.5 4.7Autos 1.1 3.0 15.3 3.4 0.3 -Tech Hardware 6.0 0.9 7.1 3.2 - -Semiconductors 2.0 0.9 0.6 7.5 - -Oil & Gas Refining & Marketing 2.3 4.0 0.7 2.2 10.2 6.3Utilities 3.3 3.9 3.1 3.4 2.2 4.5

24.9 24.0 45.9 27.6 16.2 15.5

Net Downstream - Upstream Exposure 16.8 14.5 42.0 17.2 -4.3 -2.7Downstream/Upstream Ratio 3.1 2.5 11.7 2.7 0.8 0.9



22

Finally, we note that despite perceptions that Chinese private consumption may be more 'structurally' robust than China's investment cycle particularly given the multi-year policy agenda to rebalance Chinese growth we would not regard the Global Consumer Goods sector as necessarily immune or 'defensive' in a China slowdown scenario.

As seen in Figure 29, between 2005 and 2012, Global Consumer Goods stocks did re-rate relative to their historic valuation norms largely as a result of their exposure to China and other fast growing EM economies. But even this sector has materially underperformed globally over the past year, reflecting, we believe, a growing realism about the sustainable trend-growth even of Chinese private consumption and of Chinese wages and salaries.

And (again) as seen above in Figure 24, the Global Consumer Discretionary sector now exhibits the largest correlation with China H-shares exceeding those of Materials and Energy.

Fig. 29: Global Consumer Goods sector 12m forward PE Relative to the market FTSE World sector index

Source: IBES, FTSE, Nomura Strategy Research.

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Tomo Kinoshita +81 3 6703 1280 [email protected] Minoru Nogimori +81 3 6703 1287 [email protected] Kohei Okazaki +81 3 6703 1291 [email protected] Shuichi Obata +81 3 6703 1295 [email protected]

5. Country views on the downside risk scenario

Japan

Fig. 30: Nomura forecasts for our base case and China risk scenario Base case China risk scenario GDP growth 2.5 2.0 CPI inflation 2.2 1.8 Current account, % of GDP 1.7 2.2 Policy rate 0-0.10 0-0.10

Source: Ministry of Finance, Japan; Nomura Global Economics.

Economics

China has become increasingly important in recent years to Japan's economy as it is now the biggest export destination in 2012 the share of exports to China (including Hong Kong) as a percentage of total exports reached 23%. In the past, Japanese manufacturers utilized their China subsidiaries primarily as a base to produce export goods to other advanced economies. However, as China's consumer market expanded rapidly, Japanese exports to China for domestic consumption rose. Simultaneously, as China's manufacturing industry grew rapidly and transitioned to more value-added production, China's export of consumer goods to Japan also rose significantly. In 2012, capital goods accounted for a 56.4% of total exports to China from Japan, while the share of intermediate goods and consumption goods were 31.9% and 6.8%, respectively (Figure 31).

Fig. 31: Composition of Japan's exports to China

Source: Ministry of Finance, Japan.

Given increased dependence on China, we estimate that a 1pp decline in China's GDP growth in our risk scenario would lead to a 0.5%pp fall in growth for Japan (Figure 20). Lower exports to China explain a 0.2pp reduction in Japans growth, while a decline in Japan's exports to other economies under this scenario would remove a further 0.1pp. Combining these two channels, the direct impact on Japan's growth through lower exports therefore amounts to a -0.3pp contribution to growth. On the other hand, an export slowdown would generate negative spillover effects on domestic demand in Japan, especially private investment. Combined with a decline in private consumption brought on by lower stock prices, we believe that negative spillover effects would trim another 0.2pp from Japan's growth.

As far as the impact of a China slowdown on Japans inflation and current account is concerned, lower commodity prices play an important role in containing the inflation rate and reducing the trade deficit. Our simulation indicates that a 1pp decline in Chinas growth would lower inflation by 0.4% through lower commodity prices and a rising output gap. It would also improve the trade balance by JPY2.3trn, or 0.5pp of GDP.

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Hiromichi Tamura +81 3 6703 1680 [email protected] Hisao Matsuura +81 3 6703 1814 [email protected]

Through direct and indirect channels, lower growth in China would especially hurt industries in the electrical machinery, textiles, precision instruments, chemical, plastics and rubber products, and base metal sectors, based on our estimates using an input-output table (Figure 32).

Fig. 32: The impact on Japanese industry value-added when China's growth declines by 1pp Total impacts Direct Indirect Agriculture, Forestry and Fishing 0.0 0.0 0.0 Mining -0.4 -0.1 -0.3 Coal, crude oil, natural gas -0.3 0.0 -0.3 Food products and beverages 0.0 0.0 0.0 Textiles -1.0 -0.7 -0.2 Wood and of wooden products -0.1 0.0 -0.1 Pulp ,paper and paper products -0.3 -0.1 -0.2 Publishing and printing -0.2 0.0 -0.2 Chemicals -0.6 -0.3 -0.3 Petroleum and coal products -0.3 -0.1 -0.3 Plastics and rubber products -0.6 -0.3 -0.3 Non-metallic mineral products -0.5 -0.2 -0.2 Iron, steel, non-ferrous metals and fabricated metal products -0.6 -0.2 -0.4 Machinery -0.6 -0.5 -0.1 Electrical machinery -1.0 -0.7 -0.3 Transport equipment -0.4 -0.2 -0.2 Precision instruments -0.7 -0.7 0.0 Other Manufacturing -0.4 -0.3 -0.1 Construction 0.0 0.0 0.0 Electricity ,gas and water supply -0.2 0.0 -0.2 Wholesale and retail trade -0.2 -0.1 -0.1 Finance, insurance and Real estate -0.1 0.0 -0.1 Transport and communications -0.2 0.0 -0.1 Service activities -0.1 0.0 -0.1 Others -0.2 0.0 -0.2

Note: Indirect impacts are calculated using 2011 input-output tables for Japan. The impacts do not include effects from other economies and financial markets. Source: Nomura, based on Ministry of Economy, Trade & Industry data.

Equity strategy

We estimate that China accounted for 4.9% of Japanese companies' sales and 5.7% of their after-tax profits in FY12 (Figure 33).

The regression sensitivity of Japanese companies recurring profit growth to Japan's real GDP growth rate has been 8. If we assume a 1.0pp decline in China's GDP growth would reduce Japans growth by 0.5pp, we calculate it would weigh on Japanese recurring profits by 4% (Actually, the sensitivity of Japan's real GDP growth rate to China's real GDP growth rate is high when utilising a simple regression analysis. If we just observe the data since 2005, it has been 1.4.) Fig. 33: China business contribution for Japanese companies

Source: Nomura.

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Young Sun Kwon +852 2536 7430 [email protected]

James Kim +822 (3783) 2341 [email protected] Michael Na +882 (3783) 2334 [email protected]

Our top-down recurring profit growth estimate for FY13 is about 50%, based on a USD/JPY assumption of 100. Even if a slowdown in the Chinese economy were to affect Japanese companies, we would still expect Japanese corporate profits to grow. In H2 2012, we recommended purchasing risk assets in China, specifically in the materials sectors, but we now think it is inappropriate to take on further China risk.

South Korea

Fig. 34: Nomura forecasts for our base case and China risk scenario Base case China risk scenario GDP growth 4.0 3.5 CPI inflation 3.0 2.5 Current account, % of GDP 3.9 4.5 Policy rate 2.75 2.25


Economics

Weaker domestic demand in China would primarily feed through to lower Korean GDP via a reduction in Korean exports. We assume that 60% of Koreas exports to China are for re-exports and 40% for domestic consumption and investment. According to the Bank of Korea (BOK), the correlation between each GDP component of China and Koreas exports (1995-2011) is: China exports: 0.76; China investment: 0.19; China government consumption: -0.04; China private consumption: 0.19.

In the past, as China acted as Asias main manufacturing hub Korean exports to China were mostly parts/components (65% of total) used for re-exports. If Chinas GDP growth slows mainly due to domestic demand and exports remain stagnant, the first-round impact on Korean exports would likely be limited, in our opinion, but a second-round impact would be expected: If commodity prices fall sharply and commodity exporting countries in Emerging Markets (the Middle East and Latam, mainly) see growth slow sharply, Korean exports to EM would likely fall. In January-May 2013, Koreas exports to China and South Asia gained by 10% y-o-y and 13%, respectively, but those to Latam and the Middle East fell by 16% y-o-y and 8%, respectively.

All in all, we estimate that a 1pp fall in Chinese GDP would lower Korean GDP growth by 0.5pp. In this case, we would expect the Bank of Korea (BOK) to cut its policy rate by 25bp, to 2.25%, to support growth as both growth and inflation would slow (in our current base case, however, we expect the BOK to hike policy rates by 25bp to 2.75% in H2 2014). There would also be room for the government to implement some level of fiscal stimulus. We would expect Koreas current account surplus to increase further, supported by lower commodity prices.

Equity strategy

In the equity space, the impact of a sharper-than-expected China slowdown would be limited, we believe, for the large exporters such as Samsung Electronics and Hyundai Motor in light of their well diversified export markets. Also, as we expect domestic economic growth to pick up and the housing market to recover going forward which could be further supported by a possible BOK rate cut as discussed above domestically oriented Korean sectors (such as Retail and Banking) may prove better insulated from a China slowdown. However, investors should be cautious of more directly China-dependent Korean sectors such as Energy, Petrochemicals, Steel and Machinery.

From a broader asset-allocation perspective, however, Korean equities appear unlikely to simply sail above the broader risks. Were investors to turn substantially more cautious on China to the point of further reducing broad EM exposure, Korea would suffer as well potentially from outflows as much as from the discounting process, given that after China, Korea stands among the next-largest markets in the MSCI EM universe.



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Craig Chan +65 6433 6106 [email protected] Prateek Gupta +65 6433 6197 [email protected]


Jesse Wang +886 (2) 2176 9977 [email protected]


FX: KRW appears to bear the most significant FX depreciation risk within the Northeast Asia bloc to a sharp slowdown in China's economy. Despite the expected increase in Koreas current account surplus, partly from lower commodity prices, Korea could still suffer from an overall balance of payments (BoP) deficit. As highlighted in the past six months of BoP data, despite the large average monthly USD4.1bn current account surplus, outflows from the capital and financial account have offset the surplus on four occasions. In addition, in light of weaker growth and low inflation, authorities would likely shift toward a monetary easing bias, which increases the possibility of a preference for a weaker KRW. Overall, based on our financing gap analysis (see Asia's rising risk premium, 28 June 2013), we believe KRW will be one of the more vulnerable currencies in Northeast Asia to a severe growth slowdown in China.

Rates: Korea is one of the more vulnerable economies to a China slowdown, leading, in our opinion, to a rate cut by the BOK in order to support growth and inflation. In such a scenario, we would expect the curve to steepen and the impact could be more profound if the government implements a fiscal stimulus. We would also expect volatility in the Korean rates market to pick up, in our China risk scenario.

Taiwan

Fig. 35: Nomura forecasts for our base case and China risk scenario Base case China risk scenario GDP growth 3.5 2.5 CPI inflation 2.3 1.5 Current account, % of GDP 8.0 10.0 Policy rate 2.13 1.88


Economics

China is Taiwans largest trading partner and most of its exports to China are also for re-export in the technology sector. We believe that the direct impact on Taiwans exports of a domestic demand slump in China may be limited, but the wider effects of a slower economy in general and tighter monetary conditions would have a negative impact given the many business projects between China and Taiwan that would delayed, while weaker global demand would have an indirect impact on Taiwans export-heavy economy. As a result, we estimate a 1pp decline in Chinas growth rate would reduce Taiwans GDP growth by a similar amount. In this scenario, we would expect the Central Bank of China (CBC) to keep policy rates a 1.875%, which is already very low (in our base case we expect the CBC to hike policy rates by 25bp to 2.125% in H2 2014). Instead, the government could implement a fiscal stimulus given that there is room for further fiscal spending in Korea. Taiwans current account surplus would widen on lower global commodity prices.

Equity strategy

Given the degree to which strengthening cross-Strait ties in terms of both trade flows and policy liberalization have underpinned the TAIEX in the past several years, Taiwanese stocks would not be able to sidestep a more abrupt China slowdown. A deeper-than-expected economic slowdown might distract the Chinese leadership from the agenda of deeper cross-Strait economic integration, putting on hold that key sentiment support for Taiwanese stocks. It could also prove a domestic political challenge for Taiwans ruling KMT party, which often capitalizes on China-driven economic prospects to court Taiwans middle-class voters (Taiwans next major elections for city government mayors are preliminarily slated for November 2014].

Taiwans Tech sector could prove relatively more resilient than non-tech stocks, as the former has mostly utilized China primarily as a production base to address global rather than local demand; indeed, a China slowdown could also slow the rise in Chinese production costs, including labour. Any CNY depreciation (in addition to labour-cost relief) could help improve Taiwanese profit margins. On the other hand, Taiwans non-tech companies (e.g. Consumer, Materials) suffer more concentrated exposure to Chinese end-demand. Their likely share price correction(s) would only be deeper in light of the combination of both sharper earnings-estimate



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Craig Chan +65 6433 6106 [email protected] Prateek Gupta +65 6433 6197 [email protected]

Michael Kurtz +852 2252 2182 [email protected] Wendy Liu +852 2252 6180 [email protected]


consensus downgrades and a higher valuation base of comparison in the first place, in our view.

Nevertheless, Taiwanese banks would likely benefit from Chinas policy-tightened liquidity, presumably precipitating the slowdown scenario. This is because many Taiwanese corporates with operations in mainland China would likely turn more to Taiwanese lenders to access working capital credits helping boost loan demand and expand margins at Taiwanese banks, in our view. The ideal proxy would be Taiwans large-corporate-driven banks, which also would likely feature more manageable credit cycles during the more severe downturn in our risk scenario.


FX: TWD would also likely experience depreciation pressures given its high export dependence on China and because its exports compete directly with Korea (particularly in the LCD sector where Taiwan and Korea together account for over 70% of global production). The risk of Taiwans central bank adopting a pro-growth policy stance is high. However, significant TWD depreciation could be limited given the expected recovery in the world economy and/or if China's government responds with stimulus. In addition, unless the cyclical slowdown in China leads to negative credit events, authorities in Northeast Asia generally have ample FX reserves (relative to imports and short-term debt) to support local FX, and can also repeal some of the capital inflow-related macroprudential policies implemented over the years.

Rates: Our economists estimate that every percentage point drop in Chinas growth would have a similar impact on Taiwans growth. The expectation of a rate hike (in H2 2014 according to our baseline scenario) with a poorer growth outlook would create an opportunity to enter flattener trades. However, if a sharp slowdown in China (as in the risk scenario) materializes, the expectations of a rate hike would diminish, thus reducing the attractiveness of a flattener trade. In such a scenario, an outright receive position would be a better trade.

Hong Kong

Fig. 36: Nomura forecasts for our base case and China risk scenario Base case China risk scenario GDP growth 3.5 2.0 CPI inflation 4.3 3.5 Current account, % of GDP -1.0 1.0 Policy rate 0.40 0.40


Economics

Weaker China demand would have a negative impact on Hong Kong through both real and financial channels. The number of tourists visiting Hong Kong from the mainland could be expected to fall below our base-case assumptions. For example, a slower expansion in China would affect the purchases of luxury items by mainland tourists; luxury brands customer would cut spending while businessmen may not need so many luxury watches to give out as gifts. Tighter credit conditions in China would also have a negative impact on Hong Kongs property market. Its financial service activities, too, would weaken if there was a slump in Chinas capital raising efforts. All in all, we estimate that a decline of 1pp in Chinas growth would reduce Hong Kongs GDP growth by 1.5pp. Meanwhile, Hong Kongs CPI inflation would be lower than in the base case due to lower commodity and food prices. Given its very strong fiscal position, the Hong Kong government could be expected to increase its fiscal spending, or transfer more income to low-income families if job creation shrinks due to weaker China growth.

Equity strategy

Curiously, China slowdown risks may already be more fully priced at present in Hong Kong-listed China stocks themselves than in the rest of the Asia-Pacific region and indeed globally. MSCI Chinas consensus aggregate PER, at 8.2x, is Asias second-lowest (after Koreas 8.0x) and by far the deepest historic discount, at -32% (vs. the regional average of just -6.0%)



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representing, we believe, the degree to which exploration of Chinese structural risks has dominated market attention in the past three to four years (Figure 37).

Fig. 37: Asia-Pacific ex-Japan: PER (Absolute & vs historic average) and nominal GDP


Moreover, survey-based data suggest that reduction of China relative portfolio weightings vs. benchmark over the past 12 months has been by far the Asia ex-Japan regions most aggressive (followed by Taiwan, Korea and Hong Kong, i.e. a rotation out of North Asia in favour of India and emerging ASEAN Figure 38). This, too, suggests an imminent policy-driven deceleration may largely be already embedded in market expectations:

Fig. 38: Net change in consensus country/sector relative weightings (vs. MSCI Asia ex-Japan benchmark)

Source: EPFR, Nomura Strategy Research.

0

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Change vs. Jun-2012 vs. 3-year avg. Change vs. Jun-2012 vs. 3-year avg.India 2.7 2.4 Utilities 3.6 3.2Indonesia 0.5 -0.4 Staples 1.9 1.0Philippines 0.4 0.5 Materials 1.1 0.1Thailand 0.2 0.2 Industrials 0.7 0.0Malaysia 0.1 -0.2 Health Care 0.5 0.1Singapore -0.1 -0.7 Discretionary -0.7 -0.1Hong Kong -0.1 -0.9 Info Tech -1.2 0.0Korea -0.4 0.8 Energy -1.3 -0.4Taiwan -0.7 -1.5 Financials -1.7 -1.5China -2.7 -0.2 Telco -2.9 -2.3



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It is instructive to note that equity prices do often move ahead of 1) analyst earnings consensus; 2) the economic consenus; and 3) ratings agencies. Note in Figure 39, for example, that during the China downturn and rebound of 2008-09, A-share equities inflected upward from November 2008 but GDP forecasts and consensus earnings estimates continued to decline through June-July 2009 just weeks before the stock rally peaked.

Fig. 39: CSI-300 Index (2008-09) vs. Consensus 2009 EPS and GDP forecasts

Source: Bloomberg, Nomura Strategy Research.

In assessing what approximate economic growth range China stocks may already be discounting, we note that by regional best-fit standards (Figure 40), MSCI Chinas current 1.3x PBV implies a lower ROE (i.e., roughly 9.5%) than the much stronger trailing ROE (14.8%) that China has actually been generating.

Namely, Chinas PBV is substantially lower than in other Asia-Pacific markets generating similar 15%-16% trailing ROEs such as the Philippines (3.2x), India (2.5x) and Thailand (2.4x) and closer to the PBVs of markets such as Hong Kong and Singapore, generating much lower ROEs.

This suggests that Chinas multiple de-rating over the past five years fully -70% from an average of just over 4.0x from mid-2007 through mid-2008 has already embedded expectations of a substantial erosion in return generation (whether from slower GDP growth and thus slower top-line revenues, or from eroding profit margins, but likely both).

Fig. 40: Asia-Pacific ex-Japan: Current PBV vs. 12m trailing ROE


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Craig Chan +65 6433 6106 [email protected] Wee Choon Teo +65 6433 6107 [email protected]


Extending from the above implied ROE of 9.5%, we note below that the scatter-chart of actual historical Chinese ROE vs. nominal GDP (Figure 41) equates a roughly 9.5% ROE with nominal GDP growth of roughly 6.0% i.e. the region indicated by the red circle below. Chinas implied GDP deflator in Q2 13 was 0.5%, which if unchanged in 2014 would translate nominal GDP growth of 6.0% to real growth of roughly 5.5%.

Fig. 41: China: Historical quarterly ROE vs. nominal GDP

Source: Datastream, CEIC, Nomura Strategy Research. The above can only be regarded as very approximate given, for example, that 1) the sector composition of Chinese equity markets h

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